Carbon Charge or ETS? The pros and cons

There has been worldwide agreement for several decades that to encourage wise decisions on energy production and consumption, agricultural intensification, and land use change we need a price on carbon. This would make fossil fuels and the products they contribute to more expensive, renewable energy and energy efficiency relatively cheaper, and incentivise low carbon land uses. However few jurisdictions have designed really effective systems.

Theoretically it can be achieved by putting a charge on each tonne of carbon as it enters the economy from mining or import; or by allocating permits to industry to emit a limited amount of carbon, and allowing them to trade these permits through an “Emissions Trading Scheme”, thus setting a national price.

NZ currently has an Emissions Trading Scheme which is seriously flawed. In the 8 years it has been in place it has done nothing to curb emissions, which have risen steadily. It has had no domestic cap on total emissions, freely allocates permits to industry exposed to trade competition from countries that have no price on carbon; does not include biological emissions from agriculture which are responsible for about half our total emissions; and as an eligible industrial firm’s production rises the free allocation also rises, reducing the incentive to adopt new technology. For part of its life the carbon price was cents per tonne, well below the $25 ceiling the government introduced.

So when we came to write the Declaration, in the third section on what we would pressure the Government to do, we wrote “Abandon the ETS and replace it with a carbon tax, with the proceeds going to all citizens.”

We have recently been challenged to rethink this by researchers at Motu Economic and Public Policy Research, who have published a proposal for reforming the ETS that deals with most of the deficiencies of the present scheme. We held a teleconference call to discuss the pros and cons of the two systems which you can watch below.

Not everyone will have the time to watch an hour-long video so if that's you then read on for a summary of the arguments.

Why did we prefer a carbon charge?

1. A carbon charge is transparent, certain, and easy to understand, provided it is set in law and rises by a pre-determined amount regularly. Businesses can plan with certainty, which means they are more likely to invest in renewable technology or efficiency, rather than delay to try to game the price.

2. A carbon charge does not therefore send the message that you can help the climate by being greedy and trading for an advantage. We think the psychology behind the rules and the thinking it promotes is important in the big picture.

3. There is no chance for carbon market players to make money out of arbitrage at taxpayer expense. This practice occurred from 2013 to mid-2015 when ETS participants chose to meet their near-term obligations with cheap, dodgy overseas credits and banked the credible New Zealand Units they received from the government which will be worth more in the future.

4. The proceeds of a carbon charge go to government which we believe should return them to all citizens equally, either as a citizens’ dividend or an equal tax rebate. This is the only way we can see to create political support for this “tax” as people see it come into their bank account. It will help the poor more than the rich as $1 is worth a lot more to low income people, but if it is targeted just to them it will not be universally supported. This is why we use the term “charge” rather than “tax”, which would be money that the government keeps for other purposes. If emissions do not reduce sufficiently to meet the country’s target, the charge can be increased until it does.

5. While no doubt there will be lobbying, as there is with any scheme, there are no dodgy ways to get out of a tax. It will focus people and industries on reducing their emissions. The balance between charges and dividends will be variable but can link to each other over time.

Arguments for an ETS

1. A properly designed ETS has a cap on total emissions, reflected in the total permits issued. This ensures a reliable emission outcome which could be aligned with our national target and ambition can increase over time. The government has to guess the level of an appropriate carbon charge in order to reach the desired emissions reduction, and this guess has fiscal implications for target compliance. Unlike a carbon charge, an ETS enables the emission price to adjust automatically to changing market conditions in order to deliver on targets.

2. The ability to trade units creates a flexibility to improve economic efficiency if it is cheaper to pay others to reduce their emissions as they have more cost-effective alternatives. (This depends on the units available for purchase reflecting real environmental improvements). The ability to bank units allows participants to bring forward emission reductions and manage their obligations more efficiently over time.

3. When the government introduces unit auctioning to emitters (as was recently announced), this will generate revenue just like a carbon charge, and theoretically this could be returned to citizens. However a precedent has been set under the current ETS that may be hard to change.

4. An ETS can operate with price management mechanisms which improve price predictability and guard against unacceptable price extremes, thereby capturing some of the risk-reduction benefits of a carbon charge while having the market continue to set the price.

5. Property rights have been created by the current ETS and there is a whole machinery of administration in place. Changing to a different system might seriously delay action on emissions reduction, affect the value of prior investments and undermine market confidence in government rulemaking.

1. There would be a cap on total units issued by the government for auctioning and free allocation. The cap could be set to deliver the carbon reductions required in alignment with New Zealand’s international commitments and domestic decarbonisation objectives.

2. There would be a price band with a maximum (price ceiling) and minimum (price floor) which would be implemented at auction and within which the price could fluctuate according to the market demand. This price band would limit price volatility.

3. Permits would be auctioned, creating an incentive to adopt new technology and change behaviour to reduce the permits needed and generating revenue. The market would determine the emission price based on total unit supply. Motu does not comment on what proportion of the available units would be issued free. If the current allocation of free units continued there would be little to auction. As industrial free allocation is phased out, more units could be auctioned and more auction revenue generated.

4. The cap and price band would be fixed five years in advance and updated by one year, each year. A further ten-year indicative trajectory would be developed for both the emission cap and the price band to guide future decisions and provide a 15-year investment horizon for the market

5. The government would enlist independent technical advice when setting and reviewing the cap and price band, but decisions on these issues would remain with government.

The proposal leaves open the question of whether the free permits would be intensity based (the more you pollute, the more credits you get) as now, or pegged to a previous level of production, so that there are no free credits for growth. In our view this question is important.

Common features of ETS and Carbon Charge

Motu rightly pointed out that both systems can go very well or badly wrong and can be skewed by politics. We should beware of comparing an ideal tax system, which we would probably never achieve politically, with the current seriously flawed trading system. We need to compare the best achievable version of each system. Certain problems remain that must be dealt with in either system:

1. If NZ’s trade-exposed industry faces a substantial carbon price and has to compete with overseas businesses who don’t, some portion of our producers could lose market share or choose to close down or move overseas. This may improve our emissions, but global emissions could stay the same or go up – for example if overseas production increases, using coal fired electricity. There are various ways of addressing this. The current ETS gives eligible trade-exposed industry free credits for 60% or 90% of their emissions. Legislation provides for a phase-out over time. This is a common practice in ETS in other countries. An earlier carbon tax system, which was aborted before it came into being, would have negotiated a tax exemption for firms who could show their emissions intensity was at world’s best practice. This proved so impossibly hard for the state to argue that only two were ever concluded. Some jurisdictions with a carbon tax have provided some level of exemptions or rebates to trade-exposed producers.

An administratively and politically complex alternative is a border tax adjustment where trade exposed exports are credited with a refund at the border and imports from countries with no price on carbon pay the charge at the border. As other countries adopt more ambitious mitigation and carbon pricing the scale of these adjustments would gradually reduce.

2. Both approaches require an effective system for emission measurement, monitoring, reporting and verification. At the national level, this is substantially in place since the 2002 legislation and the requirements of the UNFCCC agreement but needs to be constantly monitored and kept up to date.

3. Both systems need a way of dealing with agriculture. An ETS where a farmer can offset methane and nitrous oxide emissions by planting up a less productive part of the farm in trees, may be easier than paying a charge on emissions and receiving a credit for plantings. But both are possible.

4. Both systems need a way of dealing with forestry which provide strong and reliable incentives to conserve existing forests (i.e. discourage deforestation), accelerate new planting and manage harvesting in ways that safeguard biodiversity and increase net removals.

5. Under both systems the highest priority is a Climate budget, set by an independent Climate Commission, both legislated for and accountable but this should not be used as an excuse to delay a price on carbon. This has been effective in the UK.

So where does the debate leave the Declaration?

We felt that we could not amend the Declaration which has been signed by nearly 2,000 people, without a very strong mandate. Several of the group on the conference call were unhappy to do so. Most of us still prefer a carbon charge because it does not encourage arbitrage, rewarding values we don’t wish to encourage, and is likely to gain more public support because it is easier to understand. However we are agreed that a well designed ETS could work to lower emissions and would be vastly preferable to the current situation.

What we need is a carbon pricing system that will do the job of bringing us to net zero by 2050, is politically durable, fair, and enables predictability for businesses. A statutory Climate Commission would advise the government on this, and the ‘settings’ of either an ETS or a carbon tax.